FAURY - BorgWarner Delivers Strong Content Growth With Major BEV Acceleration On The Way

Summary

• BorgWarner posted surprisingly strong fourth quarter results, with 21% organic growth that was far ahead of <2% underlying global vehicle production growth.
• Auto production growth in 2023 is looking more muted than I'd expected, but BorgWarner remains strongly leveraged to the growth in EV build rates and could see double-digit organic growth.
• Margins remain pressured by inflation, R&D, and electrification product ramp costs, but management expects the BEV business to be at breakeven late in 2023 or early in 2024.
• BorgWarner is emerging as a leader in BEV components and looks undervalued below $60.

It wasn’t so long ago that writing about vehicle electrification brought out the “it’ll never happen … it’s just a fad (or fraud)” naysayers, but I’ve noticed that as EV production rates climb, those commenters seem to have slunk into the shadows. Likewise, the Street seems to be getting more and more comfortable with the story at BorgWarner ( BWA ), a story where leverage to electrification is definitely crucial, but also where advanced technologies for conventional powertrains still matter.

BWA stock has climbed almost 25% since my last update , enjoying a rally that has seen strong price performance for other EV-heavy names like Aptiv ( APTV ), Faurecia ( FURCF ), Valeo ( VLEEY ), and Vitesco ( VTSCY ), while suppliers with less electrification leverage like Autoliv ( ALV ), Gentex ( GNTX ), and Lear ( LEA ) have done okay relative to the broader market, but not nearly as well as the electrified names.

I continue to be very bullish on BorgWarner’s future. There are still valid concerns about the pace of the ICE-to-BEV transition and what margins will look like for BEV suppliers, but I believe BorgWarner is well-placed to emerge as a winner on the other side of this transition with a strong portfolio of electronics, motor, and ancillary product offerings.

Content Growth Drives A Great Fourth Quarter

BorgWarner grew well in excess of underlying global vehicle production in the fourth quarter, and beat the Street across most of the line items that matter. Guidance for FY 2023 was a little soft, but BorgWarner does have a reputation for starting off with relatively conservative guidance.

Revenue rose 12% as reported, beating by around 5% (or $0.06/share), but posted 21% organic growth that was far in excess of the sub-2% global vehicle production growth rate in the quarter. I attribute this to BorgWarner’s strong leverage to advanced content in power (turbochargers, timing, gasoline direct injection), as well as emissions (like EGR) and transmissions. While it’s very much true that BEV is the “sizzle” in the auto sector, it’s also true that conventionally-powered cars carry quite a bit more content these days meant to enhance performance, reduce emissions, and improve ride quality.

Gross margin declined 20bp yoy but improved 40bp qoq to 20.3%, as the company continues to see inflationary cost pressures but is getting a little more accustomed to dealing with them. Operating income rose 9%, beating by about 9%, with a better than expected operating margin (down 50bp yoy and 180bp qoq to 10.4%) adding another $0.02/share relative to sell-side expectations. Taxes also played into the beat versus sell-side expectations, and full-year free cash flow was comfortably ahead of my expectations ($846M versus $740M).

Looking at the business units, Air Management grew revenue at an 18% organic rate, missing by about 2%, while profits rose 6% (margin down 60bp to 15.5%) and beat by 10%. The ePropulsion and Drivetrain business grew revenue at a 29% organic rate, beating by almost 10%, while profits rose 20% (margin up 10bp to 9.3%) and beat by 46%. Revenue for Fuel Injection rose 18% in organic terms, beating by 9%, but profits declined 26% (margin down 460bp to 9.2%), missing by 22%. Aftermarket revenue rose 15% organically, beating by 17%, with profits up 39% (margin up 350bp to 17.5%), beating by 37%.

Guidance Is Starting To Suggest A Slower, Longer Auto Recovery But With Strong BEV Build Rates

The December reporting cycle isn’t over yet, but there’s definitely more information in hand now about underlying market trends in the auto space, and I’m having to revise some of my expectations lower. While mid-single-digit growth in North American auto builds still looks possible, weaker economic trends in the EU and China seem more likely to have a bigger impact than I’d previously assumed.

Underlining that point, BorgWarner is only looking for around 0% to 3% vehicle unit growth in 2023, with light vehicles up a little over 1% at the midpoint (with neither the EU nor China expected to grow beyond 2%). This may prove conservative, but I have to point out that suppliers like BorgWarner were more cautious than the Street and other third-party data sources on build rates for 2022 and they proved to be right (funny how the primary suppliers to an industry seem to know more about that industry, isn’t it?).

Even with modest underlying volume growth, content growth, particularly in BEVs, will be a powerful tailwind for the company in 2023. Management’s 7% to 12% organic growth target is not only comfortably above the market growth rate (8% at the midpoint), but also about 2% to 3% higher than where the Street was before.

Electrification continues to be a major force, with management expecting a 100% increase in EV-related revenue in 2023 and with EV-related sales expected to drive around two-thirds of growth. I believe BorgWarner management may actually be conservative here as well, as I expect underlying BEV production to double and I think content growth should allow above-production growth for BorgWarner. Management made further progress toward its goal of $4.5B in BEV sales in 2025 (a $300M sequential increase to $4.3B), and gave guidance for breakeven results here in late '23/early '24.

It wasn’t all good news, though, as management’s operating income guide was about 2% below the Street, with elevated input costs continuing to pressure margins (as well as ongoing investments into EV technology and EV product ramp costs). Free cash flow was also guided weaker than I’d expected, with margins accounting for some of that and costs related to the company break-up accounting for a lot of the rest.

The Outlook

The biggest changes in my outlook for BorgWarner are macro-driven – I’m toning down my expectations for auto sector growth in 2023, but also expecting better results in 2024 as the recovery stretches out a little further.

As far as the BEV side of the equation goes, despite some automakers slowing their launch plans and others experiencing some initial challenges (like Ford ( F ), for one example), the business continues to ramp nicely. I continue to believe that expectations of in-sourcing are inflated; auto OEMs that have elected to go it alone are already finding that electrification isn’t easy, and I think many would-be in-sourcers will eventually become customers of leading suppliers like BorgWarner, Faurecia, Valeo, and Vitesco.

I haven’t changed my revenue numbers all that much (up 1% in FY’23 in FY’24, up 2% in FY’25) and I’m still expecting long-term growth in the 5% to 6% range, as BorgWarner remains attractively leveraged to growing efficiency and emissions content on conventional powertrains and strong volume growth in EV production.

I’ve cut back my margin assumptions in light of management guidance, with my operating margin estimates down 50bp in FY’23 and 100bp in FY’24. My EBITDA margin assumptions also take a hit, down 45bp in FY’23 and 100bp in FY’24, but I may be taking too cautious of a cut now. I’m still looking for long-term FCF margins in the 6%s, driving FCF growth close to 7%.

Between discounted cash flow and EBITDA margin-driven EV/revenue, I believe BorgWarner remains undervalued. Between the two methodologies, I get a fair value range in the low-to-mid-$60s, well above the low-$50s average target price for the Street right now.

The Bottom Line

I expect that BorgWarner will continue to convert skeptics as EV projects ramp up and analysts see the content growth and margins that electrification will ultimately produce for BorgWarner. I’m also still bullish on the split of BorgWarner and Phinia. I wouldn’t be surprised if EV-strong suppliers retrace a bit of these recent gains, but I’d consider that an opportunity to add if you didn’t already have exposure to the space.

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